The rapid and large oil price rise
experienced in March & April 2008 has created widespread concern about its
impact on country's economy and on poor households. According to the latest
State Bank's report, quote "the sustained increase in food commodity prices
and the impact of rising costs of oil products led to unexpected rise in
inflationary pressures in the economy during the first half of FY08"
unquote. The cost of petroleum products and crude oil accounted for over 24% of
the import bill in 2006-07 and a sustained rise in prices has already created
serious trouble for the fiscal year 2007-08. If energy becomes costlier, the
cost of production will go up, adversely impacting both domestic consumers and
exporters whose products could be rendered even less competitive than they are
at present.

The increase in oil price has a
three-fold economic impact on Pakistan's economy. First, oil import bills
increase manifold because in the short run the price elasticity of demand for
petroleum products is very low. Even when the oil import volumes decline, the
bills increase. Financing of costlier oil imports took up a greater proportion
of export revenues, which is also not in very stable and good shape and, with
certain exceptions, the balance of payment deficits increase. Secondly, the
higher international oil prices are passed on domestically with certain
subsidies, and this tends to fuel inflation. Thirdly, the rate of economic
growth is also affected, either by the direct impact of the crisis, or by the
price adjustment policies, or both.

THE IMPACTS OF HIGHER OIL PRICES

THE NET OIL IMPORT BILL

The net oil import bill increases with
the increase in oil prices without correspondingly affecting GDP thus disturbs
foreign reserves and balance of payments. As per the World Bank reports, a
sustained US$10 a barrel price increase would deliver a shock equivalent to a
loss of GDP of 0.5% percent. Statistical evidence shows that there is a small
but significant negative association between the level of per capita GDP and the
ratio of net oil imports to GDP, so that systematically the Pakistan being one
of the low income oil importers suffers the most from the direct impact of
higher oil prices on the balance of payments. Growth and development therefore
tend to reduce.

REDUCTION IN GDP

Following a global oil price rise,
Pakistan's GDP falls below where it would otherwise have been, so that there is
an additional impact on Pakistan being oil importer. The reduction in Pakistan's
GDP is estimated at around 0.5% due to heavy import oil bill. .

DIRECT AND INDIRECT EFFECTS OF OIL
PRICE INCREASES ON HOUSEHOLDS

Households, which are consumers of
certain petroleum products (kerosene, LGP and gasoline) and who also purchase
other goods whose costs are impacted by oil product prices (diesel for
transportation) feel the effect of higher oil prices in their household
expenditure though the government controls the product prices and does not let
them rise by allowing subsidies. According to an estimate and number of surveys
low-income deciles are more severely affected than higher income groups and
resultantly there emerges an increase in the cost of living of general people.
An important component of this total cost of living increase came from impacts
on non- fuel expenditures, especially those on transport and food, which are
impacted by higher diesel prices. Studies also confirmed the picture that the
rural poor suffer the most, primarily because of the importance of kerosene for
these households. Small and medium size enterprises are also likely to suffer
from higher fuel costs. As said above oil prices in Pakistan are subsidized to
benefit masses. This subsidy is used as political weapon as well. As known to
all that government didn't increase oil prices for almost 18 months just to
benefit previous ruling political party so that they could perform well in the
general election. Now the new government has to increase oil prices to cover the
gap and to ensure that they could also achieve the revised rate of growth of GDP
of 6%. Keeping in mind that continuous subsidies seriously affect government's
fiscal position, which results in less government spending than, would otherwise
have been possible.

In Pakistan, government passes on less
than the full oil price increase. It has to bear the financial burden, and this
has macroeconomic consequences in terms of reduced expenditure on other items,
which in itself may be anti-poor.

INDIRECT EFFECTS OF OIL PRODUCT PRICE

The indirect effects of oil product
price is the most difficult to calculate. It requires the availability of both
an input output table and a household expenditure survey, and some method of
linking the categories in these two sources of information. For example, in many
developing countries, much of the purchase of diesel is by firms (including
taxis, buses etc.) rather than households. These companies then sell their
services or products to households. Transport costs are themselves an important
item in total food costs, and so the rise in the diesel price also makes it felt
in the food price index, and hence is felt by households. By knowing the
contribution of diesel costs to transport costs and of transport costs to food
costs, and then of the share of food costs in the total household budget, a
total picture for the impact of oil product price increases via this chain can
be quantified. Prices of almost all the items were increased even before the
government effectively increased the oil prices in March 2008. The worst part of
this story is that prices of daily use items were increased before the actual
change in oil prices by OGRA that shouldn't have been happened.

POVERTY

Lower employment prospects and the
higher inflation rate are lowering the purchasing power of the poor. The biggest
impact comes through the higher price of kerosene, which is used for cooking and
lighting. The poor is also affected by higher transportation costs. The
transport fuels, where the poorest households certainly do not own their own
vehicle, the impact of the fuel price increase is most burdensome in percentage
terms. Clearly, higher petroleum costs will increase commuting costs and,
especially in the case of agricultural economies, the cost of getting the crops
to the markets. However, governments should resist the temptation to provide
subsidies to offset the high price of energy. Subsidies constitute a serious
drain on public finances, especially if the high price of oil persists. They
will have to be financed through higher taxes, or external borrowing which will
generate a higher debt burden. Moreover, although kerosene is considered an
inferior good, it is not clear that subsidizing it is the best means to protect
the poor because it is difficult to prevent non-poor from consuming kerosene.
Discretionary fiscal response should be limited since it may be difficult to
remove in the future.

COST OF PRODUCTION

The impact on manufacturers and other
companies that use oil-based ingredients could be significant, causing a ripple
effect throughout the economy. As firms are faced with rising prices and see
their margins cut, they may have to cut back on production, reduce their other
expenses or maybe shut down. Due to higher cost of production, Pakistan's goods
are already expensive than other countries and with the continuous increase in
cost of production, it appears that going forward Pakistan's exports will hit
unless otherwise government doesn't take serious measure to control expensive
energy and switch over to cheap energy. But in an extremely competitive market
where orders are awarded on a difference of cents only such continuous increase
in cost of production is alarming.

MONETARY POLICY

State Bank may be tempted to tighten
its monetary policy in reaction to the increase in inflation. Previous oil price
shocks have produced significant increases in real interest rates which
undermined domestic investment, pushed the country deeper into recession and
produced stagflation like situation. Furthermore, a rising fiscal deficit,
combined with increasing public expenditures due to petrol consumption by public
entities, can prompt the authorities to use monetary creation to finance the
additional expenditures. As the increase in the price of oil is akin to a supply
shock, an accommodating monetary policy would contribute to inflation. It is
advisable to adopt a non-inflationary policy to avoid hyper inflation and to
maintain monetary credibility.

Although the duration and magnitude of
the increase in world oil prices is not yet clear, there is certainly enough
evidence to raise concerns about their impact on the poor. Oil prices in
international market have touched US$115.5 a barrel yesterday that is an
alarming trend. Even if this recent episode turns out to be short lived, and
long term oil prices drop below US$100 a barrel range, it will have a
substantial impact and country's economy will take some time to adjust its
indicators.

In Pakistan the inflation is high and
food inflation is even higher. In order to curtail the downside effects of this
issue the government should do not plunge into short-term remedies such as
raising prices abnormally to mitigate the upcoming risks. The new government
needs to look at the whole issue in its entirety rather than exercising easy
options to pass on the burden of oil subsidy to the consumer or accumulate debts
to pay oil marketing companies. Raising prices would be the simplest thing to
do. The estimated Rs. 160 billion liability on account of subsidy needs to be
shed by applying prudent economic principles rather than going for commercial
bank borrowing. Moreover, it would be prudent for the new government to present
the entire oil pricing picture before the nation honestly including who is
earning what, who has deprived the public money etc. A recent report pointed out
that over Rs. 50 billion worth of annual anomalous profits to the oil industry
due to faulty decision making of the former economic managers. High energy
prices should also be viewed as a signal to reduce the heavy reliance on oil and
make use of alternate clean energy resources. To this end, a number of
technologies can be used at a minimal cost.